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Understanding the Forward Premium Puzzle: A Microstructure Approach

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  • Craig Burnside
  • Martin Eichenbaum
  • Sergio Rebelo

Abstract

High interest rate currencies tend to appreciate relative to low interest rate currencies. We argue that adverse selection problems between participants in foreign exchange markets can account for this "forward premium puzzle." The key feature of our model is that the adverse selection problem facing market makers is worse when an agent wants to trade against a public information signal. So, when based on public information, the currency is expected to appreciate, there is more adverse selection associated with a sell order than with a buy order. (JEL E43, F31, G15)

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/mac.1.2.127
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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Journal: Macroeconomics.

Volume (Year): 1 (2009)
Issue (Month): 2 (July)
Pages: 127-54

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Handle: RePEc:aea:aejmac:v:1:y:2009:i:2:p:127-54

Note: DOI: 10.1257/mac.1.2.127
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  1. Albuquerque, Rui & Bauer, Gregory & Schneider, Martin, 2005. "International Equity Flows and Returns: A Quantitative Equilibrium Approach," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5159, C.E.P.R. Discussion Papers.
  2. Michael J. Fleming, 1997. "The round-the-clock market for U.S. Treasury securities," Economic Policy Review, Federal Reserve Bank of New York, Federal Reserve Bank of New York, issue Jul, pages 9-32.
  3. Tracy Yue Wang & David Hirshleifer & Bing Han, 2010. "Investor Overconfidence and the Forward Discount Puzzle," 2010 Meeting Papers, Society for Economic Dynamics 1201, Society for Economic Dynamics.
  4. Glosten, Lawrence R. & Milgrom, Paul R., 1985. "Bid, ask and transaction prices in a specialist market with heterogeneously informed traders," Journal of Financial Economics, Elsevier, Elsevier, vol. 14(1), pages 71-100, March.
  5. Giancarlo Corsetti & Amil Dasgupta & Stephen Morris & Hyun Song Shin, 2004. "Does One Soros Make a Difference? A Theory of Currency Crises with Large and Small Traders," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 71(1), pages 87-113, 01.
  6. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, Econometric Society, vol. 50(5), pages 1269-86, September.
  7. Philippe Bacchetta & Eric van Wincoop, 2006. "Incomplete information processing: a solution to the forward discount puzzle," Working Paper Series, Federal Reserve Bank of San Francisco 2006-35, Federal Reserve Bank of San Francisco.
  8. Bansal, Ravi & Dahlquist, Magnus, 2000. "The forward premium puzzle: different tales from developed and emerging economies," Journal of International Economics, Elsevier, Elsevier, vol. 51(1), pages 115-144, June.
  9. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, Elsevier, vol. 3(2), pages 123-192, June.
  10. Albuquerque, Rui & de Francisco, Eva & Marques, Luis, 2006. "Marketwide Private Information in Stocks: Forecasting Currency Returns," CEPR Discussion Papers, C.E.P.R. Discussion Papers 5604, C.E.P.R. Discussion Papers.
  11. Massa, Massimo & Simonov, Andrei, 2001. "Reputation and Interdealer Trading. A Microstructure Analysis of the Treasury Bond Market," SIFR Research Report Series, Institute for Financial Research 5, Institute for Financial Research.
  12. Rui Albuquerque & Gregory H. Bauer & Martin Schneider, 2007. "International Equity Flows and Returns: A Quantitative Equilibrium Approach -super-1," Review of Economic Studies, Oxford University Press, vol. 74(1), pages 1-30.
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